Investors that intend to construct, buy, or trade real estate property should evaluate the unique prospect of requesting an Internal Revenue Code Section 1031 exchange. By utilizing such an exchange, one can defer the acquirement of general federal and state taxes upon your gained capital. The basic premise behind this is that a taxpayer begins a like-kind exchange by relinquishing his or her property in exchange for replacement property worth either the same or more than the original property.
Like-kind real estate property has a very broad definition. In fact, the chosen replacement property need not even hold similar qualities to the original relinquished property. One could in fact exchange an apartment building for retail property or an office building. Furthermore, this rule also applies to the exchange of personal property such as a car. One can exchange a combination of real estate property and personal property for another combination of real estate property and personal property. Or one can just exchange personal property for other personal property. This is a technique often employed by corporations to get replace old equipment and furniture with new stuff.
Any property that you wish to exchange for a like-kind property must qualify under strict IRS rules. It must be some sort of investment property that is owned for either the purpose of producing income or the purpose of business investment. Property types that do not qualify include raw land, personal residences, and inventory property, to name a few. Furthermore, one piece of real estate property can be exchanged for two or more pieces of property and vice versa. In addition, property for the purpose of investment can be exchanged for property for the purpose of business and vice versa. However, keep in mind that a personal residence that you reside in cannot be exchanged for anything else, no matter what. Exceptions can be made for vacation homes or homes that are also rented out to other people.
If you do go ahead and perform a like-kind exchange, you cannot then just go ahead and sell your new property. While no official rule exists barring such an event, the IRS can attempt to have the exchange overturned in a court of law. It is recommended that you keep holding on to the new property for at least six months to avoid trouble with the IRS. Otherwise, they might become suspicious and think that you are trying to cheat them.
For the transaction to be legit so that you can have gained taxes deferred, the IRS requires that the net equity and total value of the new replacement property is at least equal to or higher than the equity and value of the property that is given up. Otherwise, you will be taxed based on the difference in equity or value. Furthermore, for the deferred exchange to be legal, the individuals involved cannot receive any monetary gain from the transaction. It must be limited to a simple exchange of property and nothing else.
For the exchange to go through, a qualified intermediary or exchange facilitator must act on behalf of the seller and buyer to process the 1031 Exchange. Keep in mind that certain people are automatically disqualified from acting the role of an intermediary. This is why many companies have sprung up specializing in playing the role of an intermediary for a small and simple fee. The intermediary will have the taxpayers involved sign a paper that limits his or her rights to use the property until the transaction has been fully processed. Essentially, this intermediary is the one that takes care of taking the property from one person and then transferring it to another.
There are four primary forms of like-kind exchanges. They include the simultaneous exchange, the delayed exchange, the improvement exchange, and the reverse exchange.
The simultaneous exchange is one where both the new and old property are closed on the same day. A delayed exchange involves closing the old property first and then later on closing the new replacement property. The replacement property is usually closed sometime later during that specific week. A reverse exchange, on the other hand, involves the new replacement property being purchased and closed prior to the old property being closed. Usually, the intermediary obtains and holds onto the title of the replacement property until somebody can be found that wants it. After that, the replacement property is closed and the titles are officially exchanged from one person to another.
The last type of exchange is the improvement exchange. This involves a person requesting that certain improvements and modifications are made to the replacement property before he or she receives it. The intermediary will obtain the title, have the improvements made, and then give the title to the new owner.
The following is the recommended approach, written in a step by step guide, on going through a 1031 exchange:
Step 1: Sell your relinquished property. Have your intermediary prepare the appropriate documentation and then sign at the bottom. The property, as well as an closing proceeds, will then go to the intermediary.
Step 2: Locate your desired replacement property. You have forty five days to find the property. It is recommended that you find three just in case you are unable to acquire your first choice.
Step 3: You now need to purchase the replacement property. You have a total of 180 days from the day you sell your own property to purchase the new property. As soon as the sale is closed, the proceeds are sent to the intermediary and the intermediary then transfers the replacement property deed to you.
The following is a quick summary of the requirements that must be met for a 1031 exchange to take place.
- An authentic and real exchange of property must happen. A direct trade of properties must happen or else an intermediary must be hired to perform the trade.
- The exchange must include real property traded for real property.
- The properties exchanged must be held for the purposes of producing income or business investing.
- The 45 and 180 day requirements for locating and purchasing new replacement property cannot be broken.
- The section 1031 code is mandated by law. Even if you did not intend to label a transaction as such an exchange, if you pass the four above requirements, the transaction will automatically be labeled as a trade of like-property.
